How are mutual funds taxed?

[thefed]

I know that divi's and short-term unrealized cap gains are paid yearly, at the current tax rate of the investor (I think).

If those divi's are automatically re-invested, they then become a part of the basis, or prinicipal...right? So they would never be taxed again?

And then you pay capital gains taxes on the realized gains when you sell the fund (as long as it was held for the length needed for cap gains taxes)

IS THIS CORRECT?

So a fund states they've averaged 11%/yr after expenses, 4% of which was from divi's according to the records. That 4% would've been taxed yearly at your then current rate. Then the 7% would eventually be taxed as cap gains in the event that the 7% gain is still there when it sold. And the divi's that were re-invested and taxed at income tax rates are now part of the basis never to be taxed again.

Just trying to clarify.

 

[wabmester]

When a fund distributes dividends, you need to know what kind of dividends they are before you can determine the tax rate. Qualified dividends have a low tax rate, but a fund will call bond interest a "dividend," and that's obvously not qualified for the lower rate. The fund will tell you what portion of the dividends were qualified as part of the 1099 the give you at tax time.

You're still taxed on dividends even if they're reinvested. Your new shares from that reinvestment have the new purchase price as the basis. When you sell, calculating the basis can be complicated by reinvested dividends, but your fund company will usually do the math for you.

Funds can make distributions whenever they like. If the fund sells holdings and realizes a cap gain, that may be distributed to you (in addition to any cap gains you might realize by selling the fund shares).

 

[azanon]

If that were true thefed, then mutual funds would have an advantage over even individual stocks that pay dividends, which just isnt the case. Even on an individual stock that pays dividends, you have to pay taxes on the dividend portion of the gain.

One of the negatives of mutual funds is their turnover (the fund mangager buying and selling stock through the year). You do have to pay taxes on this and they'll be reported to you in their respective categories, be them dividends, ST capital gains, or LT capital gains. This is where individual stocks have an edge, because except for dividiends, andindividual stock acts sort of like an IRA in that you dont pay taxes on the capital gain until the day you sell. This is only true in a mutual fund if the fund manager buys and holds everything in the fund for the given year which never happens, but sort of gets close to happening in index funds.

 

[azanon]

With the new Bush cap on LT capital gains (at 15%), the magic number now for holding either an individual stock or selling a stock mutual fund is 1 year+. If your marginal rate is high, definitely try to shoot towards holding stock positions for at least a year to qualify for this lower rate.

 

[thefed]

If that were true thefed, then mutual funds would have an advantage over even individual stocks that pay dividends, which just isnt the case. Even on an individual stock that pays dividends, you have to pay taxes on the dividend portion of the gain.

RIGHT. I'd pay on the divi's/cap gains at year end. However, if those div's are automatically re-invested, that money itself that was re-invested isnt taxed again....right? Just the gains made from those investments (re-invested divi's)....

SO, by automatically re-investing divi's and distributions, i am effectively paying tax on THAT portion of the gains then, and the rest when I sell?

I seem to get answers all over the board...lol. I'm really just trying to figure out the most cost effective way to save for withdrawels betwen ages 45 and 60. But doing so involves understanding the taxes,which i get all sorts of answers to....

 

[brewer12345]

fed, you have it right.

FWIW, I don't do reinvestment of divs in taxable accounts anymore. The tax acctouning is too much of a PITA when you sell.

 

[SteveR]

fed, you have it right.

FWIW, I don't do reinvestment of divs in taxable accounts anymore.  The tax acctouning is too much of a PITA when you sell.

I agree 100% on that! DRIP accounts are convient until you have to report taxes on them. The paperwork involved is a major headache. I too stopped my DRIPs and have gone to cash payouts. If I want to re-invest I can but I am finding it easier to just put the extra into a fund or a cash account until I decide what to do with it.

 

[thefed]

thanks! i think i got it.

and i agree with NOT auto-re-investing the div's. you might as well jsut do it when you want to.

 

[Nords]

RIGHT. I'd pay on the divi's/cap gains at year end. However, if those div's are automatically re-invested, that money itself that was re-invested isnt taxed again....right? Just the gains made from those investments (re-invested divi's)....

SO, by automatically re-investing divi's and distributions, i am effectively paying tax on THAT portion of the gains then, and the rest when I sell?

I seem to get answers all over the board...lol. I'm really just trying to figure out the most cost effective way to save for withdrawels betwen ages 45 and 60. But doing so involves understanding the taxes,which i get all sorts of answers to....

Let's say your $100 account owns a mutual fund that pays a $5 dividend.  You'll pay tax on that "qualified" dividend at the tax rate for your bracket.  You'll probably pay that tax from some other source of funds (like your paycheck) and that $5 will buy more shares in your mutual fund.  Now your basis is $105.  If you have further gains, they're referenced to the new $105 basis and that original $105 is no longer taxed.

You're right about the advantage of automatically reinvesting, so don't discard it just out of concern for keeping records.  The two biggest advantages of reinvesting all of the dividends/distributions is that you're making steady purchases over time-- a form of dollar-cost-averaging-- and you're paying the taxes as you go from money outside the fund.  Jeremy Siegel goes into excruciating detail on the long-term performance enhancements of this in "The Future for Investors".

If you're gonna reinvest then you're gonna get real good at recordkeeping & math, or you're going to use an "average cost basis" and not worry about tax optimization.  A computer program like Quicken or MS Money (or a spreadsheet) greatly simplifies these tedious tasks.  I'm enamored of Quicken's "Choose Lots" and "Minimize Cap Gains" options in making these decisions, and Money probably does something similar.

If you ask a question of two posters on this board you'll get three answers and a "That depends."  If you ask a tax question then you'll get eight or nine answers... and some of them might even be correct.  So look for the references and do your own due diligence.

 

[thefed]

oh I'm doing my DD, i learned that playigng penny stocks. I just figured this would be a good place to get a start.

Thanks!

 

[soupcxan]

Tax accounting for reinvested mutual fund dividends can be a pain unless you go with a service that makes it easy...for example, Vanguard has a handy tool to calculate tax basis for their funds, assuming you buy them directly from VG. This makes things much simplier when it comes time to sell.

If you are holding funds in a generic brokerage account that can't provide this service, then I would agree with the others that you shouldn't reinvest dividends.

TheFed, didn't you ask the same question over on Fatwallet?

 

[justin]

Soupcxan,

I'm fairly new to VG, and I was wondering if you knew how, if possible, to designate a specific "lot" when you go to sell a mutual fund. In other words, instead of selling for your average cost basis, specify a particular lot you bought at a particular price (for taking intentional tax losses). How easy is this to do? Anyone have any experience there? I thought about harvesting tax losses at rebalancing time (as soon as I have some losses!!).

 

[azanon]

RIGHT. I'd pay on the divi's/cap gains at year end. However, if those div's are automatically re-invested, that money itself that was re-invested isnt taxed again....right?

I see what you're asking now. Of course not! What would make you think that? It would be silly to penalize you for having that done automatically, when you could turn around and do the same thing manually yourself.

 

[moghopper]

If you ask a question of two posters on this board you'll get three answers and a "That depends."

4 answers and a "That depends" if any one of them went to an Ivy League school.

 

[justin]

4 answers and a "That depends" if any one of them went to an Ivy League school.

Or law school...

 

[soupcxan]

I belive VG's site can handle lot tracking but I've never actually used the feature myself.

Soupcxan,

I'm fairly new to VG, and I was wondering if you knew how, if possible, to designate a specific "lot" when you go to sell a mutual fund.  In other words, instead of selling for your average cost basis, specify a particular lot you bought at a particular price (for taking intentional tax losses).  How easy is this to do?  Anyone have any experience there?  I thought about harvesting tax losses at rebalancing time (as soon as I have some losses!!). 

 

[grumpy]

fed, you have it right.

FWIW, I don't do reinvestment of divs in taxable accounts anymore. The tax acctouning is too much of a PITA when you sell.

Just make a reasonable guess. The IRS has no way to judge whether the gain you report is correct. It only needs to be reasonable so as not to trigger an audit. Even if you are audited, the calculations can be so complicated that they would be hard pressed to prove fraud rather than incompetence. If you are a wage slave like I was, and report all income as shown on W-2's and 1099's, they have absolutely no incentive to waste their time on you. I would not lose any sleep over being certain that you calculate the capital gains exactly. Life's too short!

Grumpy

 

[justin]

A lot or all of 1099's tell you which box on your 1040/1040A or schedule D to put your capital gains/dividends, etc.

 

[wabmester]

A lot or all of 1099's tell you which box on your 1040/1040A or schedule D to put your capital gains/dividends, etc. 

I've never seen a 1099 that tells you cap gains for shares you've sold -- just distributed cap gains.   You still have to do the math yourself on shares sold.   Grumpy is probably right that the IRS doesn't try to verify your math, but this has always seemed like a giant hole to me.   I imagine they'll have their computers look up your basis information from market data someday.

Edit: of course, some places like Vanguard will calculate your average share basis for you when you sell shares.

 

[justin]

Wab, you're correct. The capital gains distributions (short or long term), interest, dividends (qualified/not) haev instructions on the 1099 or with them from most places telling you where to "fill in the blank" on your tax form. You will have to calculate your own capital gains/losses (sale price minus basis) if you sell a security.

I'm starting to wonder about finding the basis for an old mutual fund my father bought for me 10-20 years ago. What if, in 40 years, I have no idea what the basis is in that mutual fund that was bought 50-60 years earlier? Make up a good guess and go with it? I doubt the IRS could track down the correct basis if I couldn't.

 

[Martha]

I doubt the IRS could track down the correct basis if I couldn't.

True, but you have to prove you have any basis at all. The IRS doesn't have to prove anything.

 

[justin]

I wonder if "I kept this spreadsheet for 50 years, and right there is the basis in cell A4" would suffice for the IRS's evidentiary requirements.

 

[SteveR]

I wonder if "I kept this spreadsheet for 50 years, and right there is the basis in cell A4" would suffice for the IRS's evidentiary requirements.

Providing the software 50 years from now can actually read a spredsheet made today.
Besides, your number is just a number without real backup you cannot prove to the IRS the real basis of the fund share unless you have documentation from the fund itself. Otherwise it is just "your" number and is worthless for audit purposes.

The only sure way claim the basis for the fund shares bought many years ago that have no documentation is to give them a zero basis. I am sure the IRS would be fine with that. 8) Otherwise, how can you "prove" the real basis?

 

[thefed]

WHY NOT CALL THE COMPANY THE FUND/SHARES ARE WITH?

 

[Nords]

WHY NOT CALL THE COMPANY THE FUND/SHARES ARE WITH?

Yeah, good luck with that, thefed. We've been buying shares of Fidelity mutual funds for over 20 years and, if they go back that far, they'll charge you for access to their records. They probably have to send their research weasels far underground into their paper archives in the Berkshires.

Then consider someone like my grandfather, who had been buying from Fidelity since the early '70s...